The latest piece out of ML's RateLab, the bank's US Rate Strategy think tank, is arguably one of the weakest analytical reports issued by the group in a long time with statements such as:
As the reality of the FED’s firm hand sinks in, disgruntled traders operating in discombobulated markets will relax. We may have violent moves in both level and shape, but as the risk of a 1930’s depression or a Zimbabwe inflation dims, risk vectors will slide back into their longer-term ranges.
and this:
We have not changed our view. [T]he average yield of the Treasury 10yr over the past six years is 4.16% with considerable congestion at the 4.0% level. Using any combination of Real GDP plus CPI, it is hard to see a Nominal GDP of much above 4% over the medium term. So there is our cap. Conversely, with over $2 Trillion of new Treasury supply and a Foreign Central Bank community eager to diversify away from the USDollar, breaching 3% seems unlikely under even the most dire economic circumstances. This means that although professional options traders may profit from “delta hedging” the relationship between Implied and Realized Volatility, true end-users should soon significantly reduce their usage of options as a hedging tool.
Good thing black swans are just a figment of Nassim Taleb's imagination. Dear Harley - pretty charts and all, but aside from your axed position, is there anything factual you can provide aside from references to CNBC anchors who claim that the recession is over, or maybe a counterpoint to the claim that your firm only exists because Ben Bernanke had some early onset amnesia and didn't quite remember just why your new uber boss Kenny bailed all of you guys out in the last minute with your latent $15 billion in losses (and will eventually result in major civil lawsuits with huge monetary damages for BAC shareholders).
We agree with your observations that the market is pricing in virtually limitless Fed and Treasury support: if it wasn't, the S&P would be at or near 0. However, unless you assume the Socialist States of America will be the new appellation for this country in perpetuity, at some point one has to assume the removal of the backstops. Believing that the 3-4% UST range will be the "new normal" then is beyond naive. Instead of adding all the other fancy graphs (below), the most useful one to see would have been to show just how insane a 4-5% mortgage rate is in a historical timeframe, not just in the US but globally. After a credit bubble explosion with a magnitude in the tens of trillions, if there is one thing one can claim with certainty, it is that a range bound level is exactly what will never occur if the market equilibrium is allowed to be restored without the nudging power of the administration's printing presses.
Of course, for the sake of your new employer, whose fate does rest on "risk vectors sliding back into their longer-term ranges", and thus your ongoing paycheck receipts, we hope you are correct. We would be the last to suggest that a piece pushing the anti govie vol trade is in fact just the opposite of the trade that ML/BAC is currently putting on the books in anticipation of reality actually catching up (either with a bang or a whimper). On the other hand, when pundits make claims such as "In other words, the Black Swan has made his appearance and flown south for the winter" you know it is days if not hours before another massive unexpected event occurs and the southward migration of 6 sigmas rapidly reverses.
Been a while since we heard from the most popular (and profitable) research (and trading) desk on Wall Street. Last night Merrill analyst Craig Schmidt went to town upgrading pretty much anything he could get his hands on. To wit, all from the last 24 hours:
Simon Property: "We are moving from Neutral to Buy on Simon given the company’s opportunity to boost external growth (and improve SPG’s core U.S. portfolio) as they prepare to become a major player in the emerging “M&A” market in U.S. retail real estate. We are modeling acquisitions of $1 billion in ’10 at an 8.5% cap rates. These new assumptions take our ’10 estimate from $5.75 to $5.95."
Federal Realty: "Quality premium justifies Neutral rating. We are upgrading Federal Realty from Underperform to Neutral due to the fact the stock’s premium relative to its peers (on a price-to-FFO multiple basis) has contracted from 42% to 26% during the beta rally. [TD: upgrade on underperformance vs peers based on beta, not on fundamentals... fucking brilliant].
Developers Diversified: "Maintain Neutral, raising price objective. We are raising our DDR PO from $3.50 to $5.00 based on a higher forward NAV (from $3.76 to $4.84), and a modest reduction in our price objective’s discount to that forward NAV (was 5% is now 0%). We are also raising our ’10 FFO per share estimate from $1.44 to $1.59, to reflect the reduction in dilution given the issuance of fewer shares at the stock’s current price. [Give it 2 weeks until ML does another follow on here].
Taubman Centers: "Maintain Neutral, raising price objective [take DDR template, change name of company, recycle everything else]. We believe that Taubman is positioned with a solid balance sheet and has better than average liquidity than many of its retail REIT peers."
Likely much more coming over the next week as economic fundamentals and beta underperformance over the past 2 months has drastically changed the prospects for REITs.
All in all, a nice preamble for SPG to raise yet another round (2nf, 3rd, 9th - I have lost track at this point) of equity, compliments of the ever gregarious with other people's money Merrill Lynch sales/trading desk.
Sphere: Related Content
In the most recent example of taking from one pocket to pay another, Merrill and JPM underwrote 8.75 million shares at $20/share for Kilroy Realty Corp, a REIT that owns, operates, develops, and acquires Class-A suburban office and industrial real estate in bankrupt southern California. But don't bother Cohen and Steers with the fundamentals - after all not only are REITs the primary recipient of taxpayer subsidies via the PPIP pumpage of CMBS, now Arnie is making sure taxpayers double dip, and bail out his state as well. As such, for taxpayers going long a REIT debacle such as KRC makes all the sense: at the end of the day the choice is either paying yourself in advance on April 15 by buying the worst garbage Wall Street has to offer, or not paying taxes at all.
And, in a much maligned but extremely profitable tradition, all the offering proceeds of $166.7 million, will go to pay back Merrill's revolver with KRC. Everyone is eagerly awaiting the upgrades to buy yet another stock which will soon have negative FFO after all California tenants which are not too big to fail stop paying their rents.
But before we get the inevitable Strong Buy boost from the revolver repayment beneficiaries, here is an objective summary analysis of KRC compliments of Dan Amoss of Strategic Short Report:
Kilroy’s 92 office buildings and 42 industrial buildings are located in Los Angeles, Orange, and San Diego counties. The occupancy rate of Kilroy’s 12.4 million square feet of total rentable space was just 89.2% at December 2008, down from 94% in 2007. This is an important metric because not only are many of Kilroy’s tenants in businesses like mortgage sales going away permanently, but healthy tenants are gaining the upper hand in lease renewal negotiations.
Demand for office space tends to lag employment trends. The dramatic recent jump to 10.5% in California’s unemployment rate will make Kilroy’s 2009 and 2010 lease renegotiations very unpleasant. The fact that California’s state government is insolvent doesn’t help Kilroy’s lease renewal efforts. The state will likely impose higher taxes and fees on businesses to balance its budget, driving many more out of the state to havens like Nevada.
Kilroy’s tenant profile is diversified across industries, but is 85% concentrated in the following industries: professional services (34%), manufacturing (19%), education and health services (17%), and financial and real estate services (15%). Its top 15 tenants by size contributed 39% of 2008 revenue. Lease expirations are a significant risk for Kilroy shareholders, because the tenants that do renew in 2009 and 2010 will do so at steadily lower rents. Kilroy’s 10-K discloses lease information that paints an ugly picture for shareholders. In addition to the 10.8% of Kilroy’s square footage that lies vacant, leases representing another 8% and 15% of Kilroy’s 2008 revenue will expire in 2009 and 2010, respectively (see blue line in nearby chart). Yet another obscure metric shows how much Kilroy’s space is underutilized: 3.9% of Kilroy’s currently leased space is available for sublease.
Let’s take a quick look at one of Kilroy’s tenants. Bridgepoint Education is a for-profit education company that accounts for 3.5% of Kilroy’s 2008 rental revenue. It is expected to become Kilroy’s second-largest tenant by this fall if it follows through on commitments to take more office space. Bridgepoint just completed its initial public offering and trades on the NYSE under the symbol BPI. Bridgepoint is “me too” stock — one of a long list of for-profit online colleges that look to serve the interests of insiders more than students. Famed short seller Jim Chanos has gone public with the disclosure that he is short most of the for-profit education companies. Chanos considers the business model to be unsustainable, and I agree with his assessment.
Bridgepoint’s IPO looks rushed. Insiders and private equity backer Warburg Pincus probably wanted to cash out before the Dept. of Education cracks down on abuses of Title IV education funding — likely to come later in 2009. The risk factors in Bridgepoint’s SEC filings make for entertaining reading. I’ll keep an eye on Bridgepoint, because the potential loss of this tenant is a hidden risk in Kilroy’s fundamentals.
Kilroy's Debt Load Is the Biggest Risk
The biggest risk for KRC stock is the leverage on its balance sheet. Kilroy has $1.4 billion in total debt, preferred stock, and minority interest — a good portion of it built up during the office construction and renovation boom. The green line in the nearby chart was drawn from data in Kilroy’s cash flow statements going back 10 years (courtesy of CreditRiskMonitor). It is a proxy for Kilroy’s annual investment in its real estate portfolio: capital investment plus acquisitions minus divestitures — all as a percentage of total property book value. As you can see, Kilroy invested pretty heavily in 2006 and 2007, and the return on those investments is going to be disappointing.
Covenant Risk Growing Larger
Kilroy’s capital structure is roughly 72% debt, if you measure it as total debt and preferred stock (the red columns in the chart) as a percentage of the book value of real estate (the black columns in the chart). But the market value of Kilroy’s real estate will likely be lower than book value in coming years. Kilroy may have to impair the value of its underperforming properties fairly soon. According to its 10-K, the following indicators determine whether a write-down of property value may be necessary: “Significant increases in market capitalization rates, continuous increases in market capitalization rates over several quarters, or recent property sales at a loss within a given submarket, each of which could signal a decrease in the market value of properties” [emphasis added].
Write-downs would not be good for Kilroy’s coverage of its debt covenants — one of which hinges on total debt to total asset value. But the most immediate covenant in danger of violation is a minimum occupancy requirement for Kilroy’s unencumbered assets: This must be least 85%. As of year-end 2008, this figure was 92% and will head lower in 2009.
Kilroy Must Meet Daunting Obligations Over Next 2 Years
Kilroy’s $1.4 billion in secured debt, unsecured debt, preferred stock, and minority interest is roughly twice the $700 million market value of its common stock. Kilroy must fund roughly $625 million in contractual payments by the end of 2011, which includes principal and interest payments on its debt (see chart above). It will have to fund this through some combination of funds from operation, refinancing, asset sales, or secondary equity offerings.
Let’s consider how much free cash flow Kilroy can generate in 2009, 2010, and 2011. My generous estimate of total funds from operation for these three years, adjusted for the capital expenditures necessary to merely maintain its properties, is roughly $230 million. But this doesn’t include the dividend payments Kilroy must pay to its shareholders to maintain its REIT status. If Kilroy maintains its current dividend, the cash outflow over these three years will be $240 million.
This lack of free cash flow to pay down debt will force Kilroy into a scenario that destroys shareholder value. All forms of debt financing for REITs is getting much more expensive, simply because demand for credit is overwhelming and supply of credit from banks is scarce and expensive. The weighted average interest rate on Kilroy’s debt was just 4.8% in 2008. This ultra-low interest rate is a symptom of the poor underwriting standards during the commercial real estate lending bubble.
Interest rates will soar for any REIT looking to refinance unsecured debt. For example, Simon Property Group — the biggest mall REIT in the U.S. — recently issued $650 million in 10-year senior notes at 10.35%. If Simon had to pay that much for long-term financing, then the rest of the industry is in serious trouble.
Kilroy’s weighted average interest rate could easily double by the end of 2011, which would transfer much of its future rental cash flow from shareholders to creditors.
Property Sales Would Be Self-Defeating for Kilroy Shareholders
If Kilroy considers asset sales, this option would be selfdefeating. It may have to sell properties at lower values than it is carrying them on its books. Maguire Properties will be a distressed seller in Kilroy’s neighborhood, depressing property prices. Maguire has earned the distinction of having made some of the dumbest commercial real estate purchases at the peak of the bubble. Bloomberg describes one of Maguire’s recent sales:
“Maguire Properties paid $2.88 billion in 2007 for 24 office properties and 11 development sites. The purchase, from Blackstone Group LP, encompassed all of the real estate in downtown Los Angeles and Orange County that Blackstone acquired in its acquisition of Equity Office Properties Trust. The purchase came just as Orange County vacancies were rising with the collapse of the subprime mortgage industry. The subsequent credit market freeze blocked Maguire’s efforts to refinance...
“Maguire last month sold its 18581 Teller office building in Irvine for $22 million, including the buyer’s assumption of a $20 million mortgage on the property. The property was one of those purchased from Blackstone.”
What does Maguire’s office building sale mean for Kilroy? It’s just two miles away from an empty industrial building on Von Karman Avenue that Kilroy is in the process of re-entitling for residential use. This is just one example of the risk facing Kilroy’s property values.
Kilroy will likely follow in the footsteps of its strapped REIT peers and pay most of its dividends through 2011 in the form of shares, rather than cash. Kilroy management mentioned the possibility of paying the dividend in stock on its last conference call. Recent IRS guidance allows Kilroy to maintain its REIT status if it satisfies up to 90% of its dividend requirement through the distribution of new shares, rather than cash.
But this is all data, that Cohen and Steers, and all who likely bought into KRC's offering are well aware of. Plus who cares, as ML is expediently running up the stock and completely groundless upcoming upgrades are merely days if not hours away. It is now becoming crystal clear why Sakwa decided to call it a day.
Everyone's favorite REIT analyst Craig Schmidt raising his Price Objective from $48 to $52 on the second dilution orchestrated by his parent in just as many months.
But better late than never, especially when you have the REIT dilution powerhouse behind you. CLI just announced it will issue a total of 7,475,000 shares with Merrill as lead underwriter. Use of proceeds: "To repay borrowings under its unsecured revolving credit facility" which has as syndication agent...pause... Bank Of America. Unfortunately the $180 million of max proceeds will not really help BofA with their total bank exposure... Curiously CLI is not even covered by the dynamic ML REIT duo of SS (Schmidt-Sakwa). Which does not mean the two have not been busy - here are their latest actions over just the past 3 days - finding the mildly optimistic report is harder than Where's Waldo:
Duke Realty: We are raising our '09 and '10 estimates while our PO increases from $9 to $10. Maintain Neutral rating.
Kimco: Maintaining Buy rating due to the KIMs improved balance sheet strength as a result of its add-on offering. While retail fundamentals should remain weak for 09, KIMs should be one of the survivors.
Boston Properties: BXP's 1Q results solid; increasing FFO. BXP reported normalized 1Q09 FFOPS of $1.30/share when you exclude the $0.19 one-time, non-cash impairment charge related to the suspension of construction at 250 West 55th Street.
ProLogis Trust: Significant progress toward deleveraging. PLD has taken meaningful steps to improve its balance sheet although it comes with a near-term cost of earnings dilution. We are trimming our '09 and '10 estimates while our PO falls to $9.50.
Avalon Bay: Despite stronger than expected Q1 results we are lowering our rating from Buy to Neutral due to the recent stock price gains coupled with weakening fundamentals. Our new PO is $55 (up from $49).
Equity Residential: EQR reported 1Q09 FFO of $0.57 which was a few pennies above our forecast. We are raising our '09 and '10 FFO estimates by a nickel while our PO increases from $18.00 to $18.50.
Corporate Office Properties Trust: OFC reported $0.67, $0.08 ahead of our estimate. We maintain our 09 estimate of $2.41 while our NAV stays flat at $21 and our PO remains at $22, in line with our forward NAV estimate
Weingarten Realty: Maintaining 09 Est., despite 1Q surprise: We are maintaining our price objective of $13 for WRI. This assumes a 5% discount to its forward NAV. Maintain Underperform based on PO and WRI recent outperformance of REIT sector.
AMB Property Corp: Well positioned to weather the storm: AMB reported better than expected Q1 results due to higher than expected gains on development sales. We are maintaining our Neutral rating but raising our PO from $16 to $19 per share.
SL Green: SLG's results beat on one-time items. SLG reported 1Q09 FFO of $1.48. We are increasing our 09 FFOPS estimate by $0.17 to $5.67, while our PO increased $2 to $16.50, in line with our forward NAV estimate.
Now that all REITs are solidly recapitalized and chasing the 3 still non-bankrupt retail tenants with 100%-off rent offers, maybe it is time for the custodians to allow investors to short again. One of these days SPY and IWR may finally not be Hard To Borrow - who knows?
Mack-Cali Realty Corporation Announces Commencement of Public Offering of Common Stock Business Wire
EDISON, N.J. -- April 30, 2009
Mack-Cali Realty Corporation (the “Company”) (NYSE: CLI) today announced that it has commenced a public offering of 6,500,000 shares of common stock. In addition, the Company expects to grant to the underwriters for the public offering an option for 30 days to purchase up to 975,000 additional shares of common stock to cover overallotments, if any. Merrill Lynch & Co. and Deutsche Bank Securities will serve as the joint book-running managers.
The Company plans to use the net proceeds from the offering to repay borrowings under its unsecured revolving credit facility and for general corporate purposes.
This offering will be made pursuant to a prospectus supplement to the Company’s prospectus, dated November 26, 2008, filed as part of the Company’s effective $2 billion shelf registration statement. This press release shall not constitute an offer to sell or the solicitation of an offer to buy any securities nor will there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state.
With any predictive quality the equity market might have had long dead and buried, the only somewhat sane place left for investors looking at even a modicum of rationality is the CDS market. And something there is afoot, at least when looking at the Merrill - BofA decompression trade, which over the past few days is getting back to levels last seen when Lewis was discussing splitting investment from commercial banking. The outcome of tomorrow's shareholder meeting is getting more and more interesting: judging by CDS levels, one could ask if someone knows something?
Update: Calpers has just joined the ranks of Lewis dissenters ahead of the shareholder meeting tomorrow. This is likely game over for the CEO.
As documented previously on Zero Hedge, concern #1 by a large margin for the administration is the issue of commercial real estate, and more specifically the disconnect between price discovery of CRE securities (especially in equities) and their deteriorating cash flow fundamentals. Investors who have actually done their homework and have established directional bets on CRE valuations, have, over the past month, been left wondering how it is possible that equity prices of REITs and other leveraged plays on CRE could possible be skyrocketing by over 100%, despite massive rolling dilutions and increasing fundamental weakness. Additionally, for all practical purposes, recent equity raises have been used merely to pay down secured debt financing (for the benefit exclusively of underwriter banks). As REIT analysts at Merrill Lynch would be happy to attest, the "improved" balance sheets, at best afford these companies several quarters of time, absent wholesale deleveraging (in or out of court), as declining FFO coupled with massive interest expense simply means that these credit facilities will only end up getting drawn down again sooner rather than later.
In this sense the equity raises are merely a desperate attempt by a select few fund managers who are massively underwater on their REIT bets, to prop up stock prices (after all these funds have some very concerned LPs they need to answer to, and as there is a monthly P&L reporting obligation, their very viability depends on posting at least a marginal rebound for one or two months so they can "live" to fight another day). This also explains the reverse inquiry nature of most recent REIT equity raises: these are not voluntary institutional and retail investors channeling interest to the Merrill and Goldman syndicate desks: it is, in fact, the opposite. On the day before an equity raise, the head of equity syndication at Merrill will call fund XYZ and ask them, essentially, if they would be willing to throw some good money after bad. The potential side effect of a forced short squeeze or, even more sinister, the feedback loop of leveraged ETFs getting thrown into the equation as a price trajectory perpetuating mechanism, is hopefully not discussed, although after last week's cloak and dagger disclosure about Bernanke and Paulson illegally strongarming Ken Lewis, nothing should surprise readers anymore.
In my search for candidates of this possible reverse inquiry mechanism, I stumbled upon some interesting clues, which have lead me to reexamine some old Zero Hedge favorite names. I present some observations.
A few days ago, Cohen & Steers (CNS), possibly the largest publicly-traded, long-biased REIT-focused asset manager reported its First Quarter results. As expected, the numbers were horrendous, underperforming the S&P500 by a vast margin. Of course, Zero Hedge readers should not be surprised by this performance: virtually the entire CNS portfolio is comprised of long REIT positions, which in Q1 lost over 30% of their value (in addition to a massive drubbing in all of 2008). It is thus not surprising that CNS reported that it saw major declines in Assets Under Management, which dropped to $11.6 billion at March 31, 2009, a 23.2% decline from from $15.1 billion at December 31, 2008, and a 60% decline from the $28.6 billion in AUM at March 31, 2008! What is very interesting is that of the $3.5 billion reduction in AUM, a majority, or $3.4 billion, was due to asset depreciation, and only $76 million was due to net capital redemptions, a major moderation from the $2.9 billion in redemptions year over year.
What is even more interesting, is that Cohen and Steer's institutional separate accounts (or managed accounts) stood at $5.6 billion, or nearly half of CNS's total AUM. And following up on this, and most interestingly, somehow Cohen and Steers managed to convince institutions to invest $395 million in its managed accounts, despite the decline in AUM for institutional separate accounts from $6.3 billion to $5.2 billion, before new capital inflows, an 18% decline. That is some truly phenomenal marketing PR. Just who these institutions are that have a (vested) interest in providing fresh capital to a REIT manager which demonstrates a market underperforming loss in AUM across the managed account class is truly very interesting and likely source of further much more focused investigation.
The last is an open question I will return to shortly, but in the meantime, it makes sense to present Cohen & Steers March 31 investment commentary for the Q1 period. Most notable here is CNS's disclosure that without it, none of the new equity raises in March (and likely April) would have been completed.
Cohen & Steers was instrumental in these capital raisings, and was a cornerstone investor in the offerings. We believe these transactions have demonstrated to the market that high-quality REITs have access to capital and can reduce their leverage, as needed. In our view, these companies, along with others that have strong balance sheets, will weather this recession and credit cycle and remain industry leaders.
Without the inflow of $395 million in "institutional separate account"capital, CNS would likely have been unable not only to be a "cornerstone investor", but to participate at all in any of these financings, which due to their reverse inquiry nature, would thus likely never have occurred in the first place as a seed investor is always critical in order to generate additional reverse inquiry interest. The first question a syndication desk gets when solicitation reverse inquiry interest is: "Who else is participating?" Absent a clear cut answer, the offering dies right then and there. This makes the question of just where these managed account inflows came from, all the more interesting.
The innocent conclusion is that Mr Robert Steers must really believe in dollar cost averaging. Alternatively, the fact that Merrill Lynch was the lead underwriter of virtually every single Cohen and Steers closed-end fund may potentially raise a few question marks (for our readers' convenience we have compiled some of the relevant Cohen & Steers prospectuses here - please note the lead underwriter in every single instance: Global Income Builder, Dividend Majors Fund, Quality Income Realty Fund, REIT and Preferred Income Fund, Premium Income Realty Fund, Total Return Realty Fund, Closed End Opportunity Fund, and the list goes on). The not so innocent conclusion is that Merrill, as Zero Hedge discussed previously, which would be very happy offload its credit exposure (via Bank Of America's key role as lead and syndication manager on the bulk of REITs secured credit facilities), with the assistance of its equity analysts, who would upgrade the respective REITs from Sell to Neutral or Buy ratings as soon as the offering was priced, may have had an ulterior motive to work with CNS, and facilitate their new capital generation, in order for them to serve as lead investors on all of the equity offerings (dilutions) that Merrill was lead underwriter on. An even more unwholesome pattern thus emerges: Merrill sells, CNS buys (using closed end funds which Merrill underwrote or new capital from "who knows where"), Merrill upgrades, REIT pays off Merrill secured loan, CNS marks profit on position as short squeeze in REIT stock is generated, and new investors put money into CNS after seeing "phenomenal" monthly or quarterly returns.
Quite interesting for the conspiracy minded.
But that's not all. On its April 23, Q1 conference call, Cohen and Steers had some interesting observations about the state of the REIT "deleveraging". CNS President Joseph Harvey had this to say about the company's willingness to throw tons of new capital at the REITs in the recent equitization wave:
"Our approach to these recapitalizations are to provide equity to these companies, to provide solutions to their balance sheet issues. Of course, you can't create 100% uncertainty. However, we believe that the equity that we and others are providing will be sufficient to get these companies through the year 2012. So we think that's a very long time horizon. We're confident that – by that time, the equity markets, other capital markets, will have improved. So we're extremely excited about these opportunities and the position of these companies once we execute these transactions."
Looks like Mr. Harvey has not focused a lot on threat of REIT refinancings. But who cares about 3 years down the line, when in the meantime you can bump up profits on a short squeeze and generate some additional investor interest in your fund (thus maintaining your biweekly paycheck).
Some more insightful disclosure from Mr. Harvey, who responds to Merrill analyst Cynthia Mayer's question of how far down the REIT equitization process the market is.
"In rough numbers – and again, this is a moving target depending on how the capital markets open up, but to delever the US REIT sector to levels that we think are sustainable, let's say it takes 40 to $50 billion of equity capital. In one-months' time, there has been about $10 billion that's been raised. So that's a pretty significant bite out of the apple. Now, of course, that's just the US. We think there is other opportunity outside of the US.
Let me also point out that if we have seen the lows in these stocks and we're gaining confidence that that's the fact, as we think through the next return cycle for REITs, I'd break it down into three phases. Phase one is the re-equitisation of the sector. There is going to be a phase two that we believe will be very dynamic and exciting from an investment perspective, and that phase is for our universe of companies to acquire assets from the private market who has their own leverage issues. And we know because of what the debt maturity schedule looks like in the real estate industry and what the capital structure of those assets is that there will be fore-selling. And based on our experience through the early to mid-90s, we believe that the public market will provide the capital to our universe of companies to take advantage of those opportunities to acquire from distressed sellers.
Zero Hedge would beg to differ that there is anything even remotely comparable between the current situation in the CRE market and that in the early 1990's. But that is irrelevant: Mr. Harvey essentially is hoping that there will be a greater fool available, to whom CNS can offload its REIT securities, ahead of what CNS believes will be a flouring period for commercial real estate beginning in 2012, which of course is contrary to what Zero Hedge and more and more market participants believe will happen, namely the refi crunch in 2012, which will expose CRE for the massive sham it truly is.
Amusingly, subsequent the call, Cynthia Mayer, who likely is not with the program, reiterates her Sell rating on Cohen & Steers.
Another last amusing point from the CRE conference call, is Harvey's response to UBS analyst Phil Wilhelm, who asks the logical question of what exactly is it that makes CNS comfortable that the REIT market has seen the bottom, and what themes is the company seeing that can support this claim. The answer leaves much to be desired:
We're really not comfortable discussing our short-term thinking on market movements and why. That's what we get paid to do for our clients. So, I'm not going to answer your question as to what gives us confidence as to why REITs have bottomed. We feel pretty confident in that, but we'll let you draw your own conclusions on that.
As I mentioned earlier, there is probably $30 billion US in equity that still needs to be raised over a couple of year period. So that's still a lot of capital relative beside the universe, and there is over a 100 REITs, so I'd say 15 of them have raised equity already. So there is going to be a lot of activity. We believe that the share prices have overshot on the downside to discount this financial risk. So as these balance sheet issues are solved, I know the stocks have performed and that's what has attracted investors to the area. So there is no assurance that this is going to continue if share prices rise to the point where the stocks reflect the opportunity to recap, it's going to get tougher for these deals to be done. But we think as long as they're done right and we've got a very specific formula for how they should be done, the market will – there is lot of capital out there that can absorb this equity.
May Zero Hedge ask just what this specific formula for how deals get done is? Could it involve managed accounts, a short squeeze, and Merrill Lynch in some capacity? Inquiring minds want to know. Because, despite CNS' stern promise that things are getting better, I for one would be happy to challenge anyone from CNS's management team or their portfolio managers one on one or one on many, that things, in fact, are not getting better, and once the refi cliff hits, thing will likely get a whole lot worse. I also have the numbers to back my assertions. One thing is for sure: Harvey is likely correct that there is another $30 billion or so in new equity raises down the pipeline. Zero Hedge would speculate that Merill, which is likely to be an underwriter on the bulk of these, will easily generate $1.5 billion in equity underwriting fees (the customary 5%), and CNS will likely be a happy "cornerstone investor" as more and more short squeezes are sprung. Technicals will dominate as fundamentals tell each and every investor will half a brain to run for the hills.
But then again, we live in a market where fundamental don't matter, and there is much more going on behind the scenes than is being let on. And for the most convincing example of the later, I bring your attention to the April 24 Q1 earnings call by Developers Diversified Realty Corp, one of the many beneficiaries of the REIT short squeeze. I bring your attention to the very end of the Q&A from the conference call, where EVP and CIO David Oakes chimes with the following cryptic disclosure:
"And I would like to add – to chime in here too, Jim, that I was at the real estate roundtable meeting the other day and we spent a few hours with Ben Bernanke, and he's pretty confident that we're going to see this help program for CMBS up and running within a few weeks; and very helpful that that's going to start to create a little bit of liquidity in the CMBS market, and we're in the queue with one of the major investment banks to do a significant self-financing when that becomes available."
Aside from this being a blatant attempt at Reg FD breach, would this bank potentially be Merrill Lynch one would wonder? But more relevantly, just what is it that Ben Bernanke is promising managers of very troubled REIT companies such as DDR? Perhaps, once done investigating Merrill-gate and Ken Lewis, and whether or not Mr. Bernanke was instrumental in putting that deal together, direct threats to Mr. Lewis' career notwithstanding, the new York State Attorney General can take a look at just how widespread taxpayer fund misappropriation is at the Federal Reserve level in order to buy a few quarters of breathing room for doomed REITs at the expense of fundamentally sound investment analysis.
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Hey Regency, this is what happens when you don't tap ML as lead underwriter: you get the expected headline "Improving Balance Sheet" but no accompanying Upgrade or target price increase (in a note just released by Merrill Lynch/Bank of America which was somehow not a lead underwriter on this particular offering).
Still holding our breath for Schmidt's action on Weingarten. Readers will see it the second it hits the tape, likely over the next few hours.
There was a time on Wall Street when insider trading was rampant, when sellside analysts would pump stocks under the guidance of their superiors only to have their corporate finance colleagues do an equity offer shortly after, when the amount of money a bank's corporate clients paid would determine its rating, and when analysts said in internal emails a company is worthless, only to issue reports claiming the company was the next sliced bread. Then things changed for the better briefly, when Spitzer came on the stage. However, with his thunderous fall from grace in an act of utter hypocrisy, the behavior he fought so hard to curb started gradually coming back.
Yesterday, Wall Street's shadiness came back with a vengeance.
As Zero Hedge disclosed yesterday, mall REIT Kimco decided to dilute its equityholders by issuing over $700 million (including the green shoe) in new shares which would be used to buy back the company's debt, as KIM has $735 million in debt maturities over the next 3 years, and a $707 million currently drawn on its secured credit facility. One look at the company's equity prospectus reveals that the lead underwriter is non other than "scandal-central" investment bank Merrill Lynch.
There is, of course, nothing wrong with being a member of an underwriting syndicate - in fact, absent generating profits from AIG structured finance liquidations forever, banks like ML (better known these days as Bank of America's slam dunk acquisition if one listens to Ken Lewis) will need it if they want to generate revenues. However, what Zero Hedge has a major problem with, is what ML equity research analyst Craig Schmidt did hours if not minutes after the offering was announced. In a research note update, Schmidt, who now gets his paycheck from Bank Of America (this will be relevant in a second), raised KIM's rating from Underperform to Buy.
This is where visions of Jack Grubman should resurface. While Zero Hedge will not speculate over the efficiency of the Chinese Wall at Merrill Lynch, aka Bank Of America, something in this transaction stinks to high heaven.
Let's walk through the sequence of events:
1) First Merrill Lynch/BofA gets clients to subscribe to a massively diluting equity offering (105 million new shares out of 271 million pre-offering shares, or 39% dilution). The offering prices at $7.10/share, a 6% discount to the previous day closing price of $7.49. In the process Merrill pockets an underwriting fee likely equal to 3% of the offering or around $20 million.
2) Minutes after the offering Merrill REIT analyst Schmidt comes out with a report, changing the recommendation on the stock from a Sell to a Buy, thereby getting the vanilla money which makes critical fiduciary decisions merely based on what some sell-side analyst will recommend. As a result Kimco stock rises throughout the day and closes at $9.40, a 25% premium to the closing price, and a 30% premium to offering price of $7.10, which closed that very same day.
3) Notable here is that Schmidt had come out with a Sell (aka Underperform)report on the company less than two months ago, on February 5, titled "Write-downs drove the miss." Among Schmidt's concerns were the following very salient points:
Write downs, not Q4 operating metrics, are the issue
KIM’s Q4 operating metrics took a back seat to write downs in the quarter as the company reported a sharp drop in FFO as it booked $111.8mn in non-cash impairment charges. These write-downs included $83.1mn for securities investments, $22.2mn for the equity investment in JVs with Prudential and $6.5mn for development projects in addition to $4mn of severance charges due to a reduction in headcount. While Kimco’s shopping center operations held up reasonably well in Q4 (rent spreads remained positive and same-store NOI was +1.4%), the company expects far weaker results in 2009 which is common theme running through the REIT industry.
Transaction income non-existent; lowering estimates
With the extensive write-downs, KIM’s reported 4Q08 FFO of $0.04 was $0.21 below our estimate. Looking to ’09, we expect NOI to decline 3% which includes a 300bp decline in vacancy by YE09. Given the impact of deteriorating operating metrics combined with a sharp reduction in transaction activity, we are reducing our ’09 FFO estimate from $2.15 to $1.74 while our ’10 estimate drops from $2.14 to $1.60.
Lowering PO to $12.50
Due to lower projected NOI growth for ‘09, we reduced our forward NAV for KIM from $17.04 to $14.13 and as a result our PO falls from $15.50 to $12.50 which is roughly a 10% discount to forward NAV. Given the weakness in retail spending and cautious leasing environment combined with a sharp erosion in Kimco’s noncore business segments we are maintaining our Underperform rating until we gain better visibility on the retail landscape.
4) Even assuming Merrill's Chinese Wall is fully operational, it would be curious to see how the company managed to "sell" to its clients a stock offering in which its very own analyst had a Sell rating: the cynics among us would presume these very clients would have no problem buying into the offering if they knew or anticipated a change in recommendation (especially one from a Sell to a Buy), and knew they could flip the stock they bought through the offering for a 30% gain in one day!
5) And now for the piece de resistance. The company said in its prospectus it would use the offering proceeds to pay down its revolver. "We intend to use the net proceeds from this offering for debt repayment and for general corporate purposes. Our U.S. revolving credit facility is scheduled to mature in October 2011 and accrues interest at LIBOR plus 0.425% per annum. Affiliates of certain of the underwriters are lenders under our U.S. revolving credit facility and will receive their pro rata share of repayments thereunder from the net proceeds of this offering." That last bit is critical. The company's $1.5 billion credit facility, on which it had $707 million outstanding as of December 31, will be the direct beneficiary of the offering as the entire $707 million amount would be paid down with the proceeds. And what entity benefits from this paydown: none other than Bank Of America, otherwise known as Merrill Lynch!
Ah, good old circular conflicts of interest. To summarize: i) Merrill, which is probably not too happy with having lent out Kimco $707 million on its credit facility, underwrites a $720 (including a 15% overallotment) stock offering for which it gets $20 million, ii) Merrill's analyst changes the stock from a Sell to a Buy, causing it to pop 30% in one day, and allegedly allowing participants in the offering to sell their shares at a 30% gain in a day, a mindblowing annualized return, iii) Kimco uses to proceeds to repay Merrill's credit facility, cleaning out any credit risk exposure Merrill might have with respect to Kimco's underperforming properties and operations.
At least Schmidt can sleep with a clean conscience after putting the following disclaimer in his report: "I, Craig Schmidt, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report."
Another point: on March 25, another REIT, AMB properties, on which ML also previously had a Sell rating, raised over $500 million in stock - ML was not a lead arranger on the credit facility, which would end up being repaid with the offering proceeds, but was a lead underwriter on the equity offering. Another ML analyst, Steve Sakwa raised the stock from a Sell to a Neutral (5 day after the event mind you), not a Buy, on the offering. If the deleveraging thesis was indeed the critical issue here, does it not stand to reason that both stocks would have gotten the same rating (either Neutral or Buy) based on the same catalyst?
Zero Hedge, for one, hopes that Cuomo is reading Zero Hedge, as this kind of conflicted circularity would never have been allowed in the Spitzer days. Additionally, on a recent trip, this author stumbled upon a mall in a major metropolitan area where a Michael's store (another LBO special) had recently vacated thousands of square feet of retail space: the beneficiary of this lack of future cash flow: Kimco Realty Corporation.
In conclusion - to those that managed to get in on the stock offering: congratulations. The 30% return in one day is nothing to sneeze at. To all those other retail and institutional accounts, who piggybacked, and all day were buying the shares sold by the follow-on participants (likely using Merrill's brokerage desk as an intermediary, thereby generating even more profits for the company), hopefully you see something about the dreary mall REIT space that Zero Hedge is missing. Then again, as these purchasers are likely the very same people who are convinced that all the bad news in this market are lagging indicators, with all the seasonally adjusted "good" news are leading, the fair price of KIM to them is likely much, much higher. We hope they are right: in the meantime it never hurts to look at a cash flow or FFO model, and determine just how much cash a 38% equity-diluted KIM will be generating in the future as the bulk of its mall tenants either go bankrupt or decide they simply can not afford the rising rents that retail REIT operators hope to charge.
We are surprised to have missed this the first time around. On page 4 of the Cuomo accusations against Merrill (and Lewis), the Attorney General raises a huge allegation against Merrill's trader employees: the AG claims that traders "willfully" manipulated their P&Ls, potentially by up to $7 billion, in order to make it seem they were more profitable in advance of the early mid-December bonus evaluation, knowing full well they would subsequently remark their books lower, having been already paid for the previous fake P&L number.
The Office has also learned that, less than a week after Merrill voted its premature bonuses, Merrill determined that it would incur an unexpected additional $7 billion in losses for the fourth quarter of 2008, beyond the $8 billion it was already anticipating (Id. at Ex. D at 9-11 and Ex. H at 128-29). It appears that some of these losses may have been booked by Merrill employees who marked down their portfolios only after their 2008 bonuses were set (Id. at Ex. W). Despite the gargantuan unexpected losses, Merrill did not reconsider its bonus awards (which had been voted but not yet paid out) and Bank of America neither requested nor demanded that Merrill reduce its bonus pool (!d. at Ex. C at 106-07, Ex. D at 115-17, Ex. E at 86, and Ex. H at 28). Again, these material developments were undisclosed to the company's shareholders or to the legislators considering how to salvage the American banking system (!d. at Ex. C at 146-49).
As any derivatives trader will attest, this calendar "straddle" as it is lovingly called by some, is by far the oldest trick in the book, where multivariate models' inputs are jiggered in order to spew one number, only to have the correction subsequently "discovered" and fixed at the bank's expense while the bonus has already been pocketed. It is also a reason why many banks have pushed their bonus determination late into the subsequent year so that they are able to have at least semi-audited numbers serve as the basis for bonuses.
If Cuomo pursues this avenue successfully and obtains proof of malfeasance, the consequences would be much more dire than a mere slap on the wrist and bonus disgorgement, as mark manipulation does have criminal connotations associated with it, for both the perpetrator and the enabler/supervisor. It is likely that many if not all derivatives traders at Merrill are likely sweating bullets right now and "opportunistically" looking for exit opportunities in an attempt to cover the tracks expeditiously before the Attorney General's office realizes that there are such things as desk trading blotters that keep track of any trade done during the day, and any P&L mismatch between the "official" record and the trader's own would be immediately obvious by just comparing entry/exit levels on the blotter.
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